Just one year shy of a decade of investing my own money, I find that while I'm pleased with my portfolio, there's room for improvement. I'm spreading my money across too many positions and not putting enough cash into my best ideas. As someone who spent his first five investing years with a portfolio that never exceeded 10 companies, I've allowed the idea of quantity over quality to seep in, and I now find myself holding more than 20 companies.
That provides diversification, but not much more than I'd get by holding a more Buffett-and-Munger-type focused portfolio of 10 to 15. It's my goal to get back to just such a concentration of companies, with a heavier focus on my top five ideas than my bottom five. I'm sure many other investors could benefit from a similar approach, so I'm going to share the five traits I'll be looking for in the investments on which I plan to double up.
1. An understanding of the business and its underlying fundamentals.
This is the simplest of all the requirements, but it's something that investors often overlook. It goes deeper than knowing that Wal-Mart (NYSE:WMT) is a large discount retailer. It's about understanding the company's competitive position and what increases or decreases sales and costs -- for Wal-Mart, that's distribution, inventory management, and its control over its real estate, to name a few.
2. Strong competitive position.
The best investments offer customers unique goods and services, making them more able to endure in the long term. This strength can come from patents, like those held by pharmaceutical firm GlaxoSmithKline (NYSE:GSK), or from licensing rights and product development like Electronic Arts (NASDAQ:ERTS), which also enjoys a recognizable brand. All of these qualities allow companies to maintain high returns on capital and equity, and stay profitable over the long term.
3. Shareholder-friendly management.
Management needs to show that its interests are aligned with those of its shareholders. This manifests itself in many ways, but the obvious indications are sound allocation of capital, opportunistic share repurchases, increasing dividends, and moderate compensation and dilution from stock options. Claire's Stores (NYSE:CLE) is a great example in this area.
4. Strong or improving financials.
The most important thing here is not to confuse lack of debt with financial strength. I'm just as happy to consider a debt-free company like Kenneth Cole Productions (NYSE:KCP) as I am a company with a moderate amount of debt such as Home Depot (NYSE:HD), so long as the cash flow is there to cover interest and debt payments. Beyond debt, I want to see companies whose return on invested capital exceeds their cost of capital. This means that the company is generating cash rather than losing it, which will improve its free cash flow generation over time.
5. A fair price.
I've saved the most important step for last. If everything else looks good, but the stock is overpriced, the company might be a candidate for my watch list -- not my portfolio. Paying a fair price means being fanatical about valuation and discounted cash flow analysis.
Foolish final thoughts
Finding companies that meet all five of these criteria won't be easy, but I'm not expecting to hold more than eight to 10 companies in such a high concentration. To make the strategy work, I plan to gradually build up positions in companies like Johnson & Johnson (NYSE:JNJ), which I currently own and think is fairly valued to slightly undervalued. I'll most likely sell a few companies that come up short on one or more of the items on the list. But here's the key to this strategy: By being conservative with discounted cash flow valuations, I should avoid a large number of expensive mistakes that would otherwise destroy capital.
To get started with a value-based approach like this, consider a free 30-day trial of Motley Fool Inside Value. With your free trial, you'll get access to the two most recent selections, all past recommendations, our online discounted cash flow calculator, and our dedicated Inside Value discussion boards. Click here to learn more. There's no obligation to subscribe.
This article was originally published on Jan. 12, 2006. It has been updated.
Nathan Parmelee owns shares of Johnson & Johnson but has no financial stake in any of the other companies mentioned. You can view his profile here . Wal-Mart and Home Depot are Inside Value recommendations. Electronic Arts is a Stock Advisor recommendation. GlaxoSmithKline and Johnson & Johnson are Motley Fool Income Investor selections. The Motley Fool has an ironcladdisclosure policy.
